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Steve Windhaus Ask the Small Biz Adviser

Last year's loss, this year's deduction

Dear Small Biz Adviser:
In the first year of business, I produced about twice as many expenses as I produced income. However, in the following year I will do better than break even. Is there a way to deduct my losses from one year to the earnings of the next?
Thanks
W.

Dear W:
You clearly indicate a strong sense of learning and finding every possible means of creating a profitable business. Your request for finding a means to save on tax payments this year for losses on last year's net loss demonstrates how obstacles can be turned into opportunities.

One very important assumption: You operate a corporation, but I will consider proprietorship issues.

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Yes, you can carry forward net operating losses from a previous year. But there are limits, so pay attention to the details.

First, for the benefit of all readers, let us define a net operating loss (NOL). Subtract all your deductions from gross operating income. If the deductions are greater than the gross operating income, you have a NOL.

However:

  • You cannot use the previous year's NOL as a deduction when determining this year's NOL.
  • If your company received any dividends from any U.S.-based corporations, it can deduct -- with restrictions -- 70 percent or 80 percent of those dividends from the gross income. Consider the example offered by the IRS:
Income from business
$500,000
Dividends
150,000
Gross income
$650,000
Deductions (expenses)
(625,000)
Taxable income before special deductions
$25,000
Minus: Deduction for dividends received, 80 percent of $150,000
(120,000)
Net operating loss
($95,000)
  • If you are a public utility, dividends paid out can be deducted from the gross income.

I don't suspect you are a public utility, but suggest you review IRS publication 542 to learn more specific details on each of the three issues above.

Another limitation there is the matter of time. You have up to 20 years over which to carry forward losses from a previous year. Depending on your net profits in preceeding years, the amount of loss you can apply is limited. Again, IRS publication outlines those limits.

General requirements for applying previous years' NOLs include:

  • You actively participated in the operation of the business. It is not sufficient that you were simply an investor.
  • Your investment in the business is of a sufficient amount.
  • The business loss on Schedule C is sufficient to offset income from any other sources.

Schedule K, Form 1120 is used to file the NOL in a carry-forward circumstance.

There are also issues related to closely held corporations. There are five conditions defining that term, and publication 542 details those matters.

As you can obviously deduce from this column, there are issues strongly suggesting the need to consult a tax accountant to interpret the terms, conditions and procedures you need to apply when using a NOL from the previous year. However, the expense incurred consulting the accountant is also tax deductible.

This entire column has addressed corporations. As you can see the details and issues are significant of content to warrant an entire column. If, by chance, you are a proprietor, then please view IRS Publication 536 for NOL as a proprietor (download a free copy of Adobe Acrobat Reader to view the file).

-- Posted: Jan. 8, 2002

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See Also
5 business tax moves to make now
Small business tax breaks

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